I’m not sure if Texas is more famous for its football or religion. My church likes to combine both with a Sunday night flag football league.

I played on the defensive line last night rushing the passer. The quarterback rolled right. I blitzed trough the two offensive lineman guarding me and got within 3 feet of the quarterback. Just as I dove for the flag around his waist, he turned to throw the ball. My eye crashed right into his knee, followed by my face sliding across the turf (hence, the bloody cut above my eye).

I may be the first man to bleed during a flag football game, but the minor wound reminds me a lot of trading. Taking your licks with no goals or purpose is dumb. Nobody sets out to get hurt. Accepting losses and learning from them is smart.

The author freely admits that he may be the first man in history to bleed from flag football.

A lot of readers get caught up in the idea of winning all the time. Pick your favorite sports team: the Blackshirts, the Yankees, the Cowboys, the Brazilians in the last World Cup. The world’s most storied sports teams don’t win every single game. They don’t even win every season (Cowboys fans know what I’m talking about).

Drop down to the individual level. Is Cristiano Ronaldo a ball hog? Does Alex Rodriguez hit every pitch?

Even the world’s most elite athletes have strengths and weaknesses. It’s ridiculous to expect anyone to perform their best every single day.

I’m especially directing this at newer forex traders. At the risk of offending you with reality, you need to hear this if you’ve been trading for less than 6 months. Your expectations for trading are out of this world ridiculous.

Why you started trading forex

The Challenge

More experienced traders – even the ones struggling with losses – will freely admit getting into trading for the wrong reasons. I started trading because I’m over-the-top competitive. I hate being in 2nd place, but I thrive on being challenged. Beating Mr. Market is extremely difficult. I placed my first trade because I liked the challenge.

The Gamblers

Fewer people will admit to gambling. They’re “investing” or “trading.” Among this group, I’d wager (pun intended) that 90+% of them attempt to scalp at some point. Unless you have a very clearly defined strategy, scalping is the forex version of the slot machines. You see the flashing lights and numbers bouncing everywhere, but over the long run you’re destined to lose.

I’m the guy sitting on the far left side of the bench.

If you’re guilty of scalping gambling, run some back of the envelope numbers. Where do you place your stop losses? What’s your average take profit?

Say that the stop is 15 pips away and that you average 3 pips of profit. Your typical spread is 1.5 pips. That means that you really have to earn 4.5 pips on every trade (3 pip TP + 1.5 pip spread), but you only get to keep 67% of the profit (3/4.5). Even before trading costs, you have to be right in 5 out of 6 trades, 83.3% accurate, to break even. With trading costs added in, the minim accuracy to break even is an astounding 90.1% of the time and you still would not have any profit.

Redundant question alert! Is it realistic to grind out an extra income by being 91.1% instead of 90.1% accurate? It’s absurd.

The Greedy

The final group of traders get involved with forex out of pure greed. It’s all risk, all the time with these guys. I routinely get emails touting a million bajillion percent returns in a month. It happens every month.

I remember FXCM’s King of the Mini contest. Anyone with an account balance under $10,000 was automatically enrolled. Whoever earned the highest percentage return that month won the content prize of $2,000.

Some small trader in Pakistan would turn his $300 mini account into $5,000 in 30 days. It’s true that somebody in the world is doing that as we speak. What’s also true is that their final account balance will be $0. They will invariably blow up. Nobody is ever smart enough to take the profits and run. You are not smart enough to take the profits and run. You’re not the exception. Everyone does this.

Do you know how I know? Nobody ever won the king of the mini contest twice! The client blowing up within 30 days was the closest thing to a sure bet. Trading on leverage that enables spectacular returns isn’t just dumb. It’s suicidal.

The new type of forex trader that doesn’t exist is the guy that enters with an actual business plan. Or even more amazing would be an actual strategy.

This prepared neophyte trader doesn’t exist because beating the market requires experience. And let’s be honest. Experience is a synonum for losing money.

You can throw your money away through gambling or greed. Or you can get an education with your tuition money.

How to Get Hurt for a Good Purpose

The element which makes trading insanely difficult is the lack of feedback. When new trades swap strategies every 3 days, it’s utterly impossible to learn why something worked or failed. The only thing that you really control in the market is yourself and especially, controlling the feedback mechanism.

Any trader that’s losing needs to apply their tuition money to a set, defined strategy. The strategy cannot change. When you observe the profit and loss of a strategy over 6 months, you observe how seasons and varied market conditions impact the performance. You’ll even start to get the “uh-oh” feeling in your stomach ahead of certain trades, only to realize that your intuitions are completely wrong. It’s only when you get the uh-ohs and your feelings are correct over and over again that you know to trust your instinct instead of fearing it.

Your tuition strategy

The first step is to write your tuition check. Kiss the money goodbye. You’re not doing this to earn money. You’re trading the money for experience.

This strategy consistently covers long stretches of time with consistent returns. It’s prone to catastrophic failure, though. All mean-reversion systems are. Nevertheless, I feel it is a good system.

Chart: AUDCAD H1Indicator: SMA 50 applied to the closeRules:

Buy when the price crosses and closes below the SMA 50.

Sell when the price crosses and closes above the SMA 50.

Place an emergency stop loss 1% of the current market price away from your entry.

Your lot size should be 2x your trading account. That means your minimum tuition check needs to be $500 so that you can at least trade 1 microlot, which is worth $1,000.

Aside from the market rarely hitting your stop loss, you’re in the market 100% of the time. You’ll notice streaks of winners and streaks of losers. You are expected to keep trading during losing periods. You’ll be convinced that the next trade will be a loser. Maybe it is, but you won’t have the experience to know if your intuition meant anything or if luck happened to deliver a loser.

You are not allowed to exit a trade at any moment in time other than when the bar closes. Taking profits 45 minutes into a 1 hour candle is cheating. Again, you do not have the intuition to know if this improves or hurts your overall performance.

As for my face, the sacrifice was worth it. My pressure on the quarterback made him force a pass… right into the hands of my teammate.

The vast majority of traders obsess over the percent accuracy of their expert advisors. Intuition makes it seem like that the more often a trader wins, the greater the chances or turning a profit. Alas, such an approach ignores a critical variable.

The average win-loss ratio plays an equally vital role in determining the net outcome. I meet a lot of would be scalpers. High frequency trading is incredibly popular, but a lot of traders involved with it only do so because it puts easy points on the board. They don’t pursue a strategy because it has any positive expectation. In other words, they are gambling and not trading.

One of the reasons that I love trading so much, and why I generally dislike gambling, is that you are always in control of the potential payout and the payout ratio. When I play blackjack, I only control the risk and payout. I do not control the ratio of the payout at all. It’s always 1:1.

My decisions in blackjack can only realistically improve the odds to 50%. More than likely, my game play will lower the odds below that threshold. Making decisions repeatedly will overwhelmingly result in human error. It’s our nature.

When I open my forex account, each trade commences a new round in the game. The critical difference between trading and blackjack is that I control the ratio of the payout, plus I still control the risk and quantity of the payout. The net outcome can still move against me due to random chance. The key distinction is that the typical outcome should shift in my favor with an algorithmic trading system.

One of my favorite trading books is Van Tharp’s Trade Your Way To Financial Freedom. We’ll be talking about this one soon; it’s the next item on Jon Rackley’s reading list. One of my favorite aspects of the book is its emphasis on money management strategies and trade expectation.

The term money management connotes many things to many people. The more accurate phrase would be to describe it as a position sizing strategy. When entering a trade, you realistically need to know:

What is expected loss as a percentage of the account?

What is the expected gain as a percentage of the account?

What is the percent accuracy of my trades?

Answering these questions accurately leads to the decision of how many lots, contracts or shares to trade. Controlling the size leads to controlling the outcomes. When you control the outcomes, you ideally earn a profit for your efforts.

Fixed fractional money management

Notice that I said percentage of the account in the bulleted items and not the dollar value of the trade. Thinking in terms of dollars is easier on the mind. The problems is that it ignores the wonderful benefits of exponential growth.

Every financial advisor on earth warns you that compound interest, which is a form of exponential growth, is the strongest force working for you with investments or against you with debts. Applying the same concept to trading, you want to put the power of compound growth on your side.

The fixed fractional formula is an ugly way to telling you to use exponential growth in your trading strategy. Say, for example, that you elect to risk 1% of the trading account based on the distance to the stop loss. If you have a $10,000 trading account, that’s only $100 of risk. Say that the trade works out and that you made $100. The next trade should risk $101.

Try not to roll your eyes at that one. Risking an extra dollar seems trivial and nit picky. I assure you that it is not.

I’m really not sure how to explain how all those little differences add up, but they do. I wrote a money management calculator a few years back that calculated how fixed fractional money management affects returns. The little things really do add up. With a very slight probability of winning and 50:50 odds, the returns were overwhelmingly larger when using a fixed fractional approach instead of a fixed lot approach. You should increase the position size after winners and decrease the position size after losers.

Percent accuracy is half important

If I paid you $1 for every win and you win 99% of the time, should you play my game?

You don’t have enough information to make a decision yet. You need to find out what happens when you lose.

If you lose $100 or more on the trade that only loses 1 time in 100, you should never play my game. You will lose if you play too often. And no, there is no such thing as just playing ten times and stopping. You have the same risk of losing on the first trade as you do on the 100th. It’s not safe to play at all.

The only way that you should decide to play the game is if the total payout is better than even. The total result of wins equals 99 trades * $1/trade = $99. The one loss must be less than $99 to give me the green light on playing.

If I lose $80 one time and make $99 on the remaining trials, then I will have an average win loss ratio of $99/$80 = 1.24. A system like this would be wildly in my favor.

A 60% winning accuracy is a lot more likely to happen in the trading world. Let’s say that I make $100 on every winning trade. My total winning value is 60 trades (out of 100) * $100/trade = $6,000. The maximum average loss that this system could tolerate is:

The maximum average loss that we can tolerate is $6,000 / 40 trades = $150. I should consider trading this system if the average loss comes in at $149 or less. The smaller the average loss, the greater the net outcome.

Kelly formula for Forex Trading

One problem we face with money management strategies is choosing the percentage of the account to risk. The difference between risking 1% or risking 2% of the account equity is simply one of proportion. One of the options either provides a risk-reward profile suitable to the trader or it doesn’t. The larger the appetite for risk and reward, the bigger the number involved.

The Kelly formula removes the proportionality for the question and takes a different approach: how do I make the absolute largest sum of money over time using my trading statistics. The goal is to make the maximum amount of money without getting margin called.

The formula to use is K = W – (1-W)/R where:

K = percentage of capital to be put into a single trade.
W = Historical winning percentage of a trading system.
R = Historical Average Win/Loss ratio.

The approach is most suitable for those trading small accounts, perhaps those with only a few thousand dollars, that they want to grow with maximum aggression. Losing a few dollars is thoroughly unpleasant (been there, done that!), but it’s not financially devastating, either.

It’s important to keep in mind that the Kelly formula attempts to push the trading system to its absolute maximum without busting. Knowing how close it is to the edge of busting, it’s critically important that you understate the good assumptions and overstate the bad ones. Drop the expected percent accuracy by several percentage points to accommodate the chance of error. Lower the win:loss ratio for the same reason.

The easiest way to reduce error and the chance of acting too aggressively is to make sure that you calculated the EA’s percent accuracy and its win loss ratio on a large enough sample size. I would consider 100 trades as the absolute bare minimum. 300-400 is sufficient. 1,000+ trades makes for an adequate sample for most expert advisors and trading robots.

Of course, you can always take the easier approach and simply cut the Kelly formula’s risk suggestion in half. It adds a bit of scientific flair to the strategy, while minding the fact that we are human. Watching an account drop near zero will break the heart of even the most battle tested trader. It’s impossible to stop caring about drawdown, which the Kelly formula totally ignores.